Hedge funds - the best is yet to come

Hedge funds have been slammed in recent years as poor performance deemed them a disaster for investors. Despite this, Janine Mace finds the industry remains positive, with the general consensus being that the good times are still to come.

Like misbehaving football players sent to the sin-bin, hedge funds have been out of the game. But now they’re back and keen to take a run after the drubbing they took in the fourth quarter of 2008.

Michael Coop, head of alternative investments at Ibbotson (formerly InTech), is one expert predicting a bright future for hedge funds. “The outlook is the best in years thanks to less capital competing for an unusually wide range of opportunities.”

AMP Capital portfolio manager international and FDF Matthew Hopkins believes hedge funds have proved their worth. “Hedge funds have done their job, on average, in recent years and for any portfolio they are a key component,” he says.

This view is shared by Jana head of investment outcomes Ken Marshman, who argued throughout 2009 that the flight of money away from the sector left the remaining hedge funds with a range of well-priced opportunities.

In fact, he believes many investors should increase their positions in the sector. “We see many hedge funds as providing a degree of protection against the risks of the ‘new normal’ investment environment,” Marshman says.

These opinions are at odds with the common perception that hedge funds have been a disaster for investors — something not supported by the statistics.

In Australia, while hedge funds underperformed the Australian Securities Exchange (ASX) in the 12 months to 1 April, 2010 (which returned 38.65 per cent), data from research house Australian Fund Monitors (AFM) shows their performance was far from dreadful.

Single funds achieved 20.33 per cent over the same period, while the return for AFM’s All Fund Index was 16.72 per cent and 24.88 per cent for the Equity Based Fund Index.

AFM chief executive Chris Gosselin believes the recent performance of hedge funds has been overshadowed by the heavy losses in late 2008 and the liquidity problems that occurred in some hedge fund of funds.

“In 2008-09 the majority of hedge funds did a fantastic job in a very difficult trading period,” he says.

Looking back, looking forward

This is a picture Coop believes is more accurate than the idea hedge funds failed investors when the going got tough.

“Most of the losses for hedge funds occurred in September and October 2008. Hedge funds did a good job of preserving capital before September 2008, and in 2009 preserved capital early in the year and benefitted from the normalisation of markets in the second quarter,” he says.

Even during the global financial crisis (GFC) turmoil, losses did not occur in every hedge fund. “Almost 25 per cent of hedge funds in Australia in 2008 produced a positive return,” Gosselin points out.

He says performance in the sector is varied and depends on the strategy employed by the hedge fund manager. Just as some listed shares fell 90 per cent and others only 10 per cent during the GFC, hedge fund performance was similarly dispersed.

“The performance of hedge funds recently also depends on the timeframe you are speaking about,” Gosselin notes.

Zenith Investment Partners associate director Ben Davis agrees the performance of hedge funds depends on the strategy and the timeframe, and points out some funds that were successful during the GFC are now doing poorly.

“Sectors that provided true diversification and performed well in the downturn have lagged [since] the GFC. These include the global macro and CTA sectors,” he says.

“On the other hand, sectors that struggled during the GFC have rebounded strongly. For instance, market directional strategies have rebounded as a result of these funds having some exposure to equity markets. Relative value strategies have also benefitted from a return of liquidity in markets.”

According to Davis, performance has been mixed due to the different return drivers for the various hedge fund strategies. “Even within the 20 to 30 retail funds we research, there has been a large degree of divergence in performance outcomes,” he says.

Hopkins believes the situation has now turned around for most hedge funds. “The performance numbers have been very stretched on the downside, but they have bounced back in 2009.”

The dramatic rebound in equity markets had a significant impact on hedge fund strategies linked to these markets.

“Those funds that have performed best in the past 12 months have mostly been those with equity market exposure such as long/short. Conversely, those without equity market exposure have performed poorly,” Davis says.

Gosselin agrees equity market exposure was important last year. “Non-equity based funds did well in 2008, but 2009 was the mirror image of 2008 in that those that did well were the 130/30 funds and equity-long funds. They were benefitting from the equity market rise.”

Opportunities on offer

When it comes to the next 12 months, hedge funds that benefitted from their equity exposure in 2009 may find the going a little tougher.

With 60 per cent of all Australian hedge funds being equity-based funds, the performance of the ASX is a key driver of returns and the current flat trading environment is offering local managers fewer opportunities to make money.

“From September to March 2010 the ASX has been trading in a 4000 to 5000 point band. With no strong trend in equity markets, the performance of equity-based hedge funds is reduced,” Gosselin explains.

Hopkins is more upbeat about the performance prospects for hedge funds over the next 12 months.

“With an active management strategy and volatility in the markets from factors like high government debt and currency pressures, it creates the potential for hedge funds to take advantage of it and creates the opportunity for them to make money,” he explains.

“AMP is looking to take advantage of where there are inefficiencies in markets. When everything is moving together it reduces the amount of opportunities to invest. The higher the correlations are, the harder it is to invest.”

Coop believes there are significant opportunities on offer that managers will be able to exploit.

“The transition from extreme monetary and fiscal stimuli to policy settings more consistent with economic recovery provides opportunities for macro hedge fund managers to exploit large changes in interest rates and consequent potential effects on exchange rates and bond markets,” he says.

“Similarly, the ongoing unwinding of extreme leverage in companies and investment funds is forcing more hard catalyst events such as refinancing, mergers, asset sales and bankruptcies, which can be exploited by event-driven credit and equity managers.”

Consolidation in the hedge fund market is also expected to create opportunities through reduced competition. Hopkins points out that at its peak the total global hedge fund market stood at US$1.9 trillion, while at its lowest point it slumped to US$1.3 trillion. Total funds under management have so far recovered to US$1.6 trillion.

Restructuring for returns

Davis believes the restructuring currently occurring in the hedge fund space will also assist performance — particularly when it comes to diversified and multi-strategy funds.

“Funds are now more focused on fee efficiency, return efficiency (through reviewing strategic portfolio allocation settings), liquidity and transparency,” he explains.

“We have also seen some good initiatives from managers such as Jana, AQR, Select, FRM and Man in addressing some of the past issues associated with hedge funds.

“Based on these changes, we believe we have a better suite of retail alternative products to select from now relative to before the GFC,” Davis says.

Fee reductions by both single hedge funds and hedge fund of funds will also have an impact.

“There is a lot more positive outlook than in the past two to three years due to better fee structures, as this creates greater potential for return pick up,” Davis says.

These improvements will help deliver better risk-adjusted outcomes for investors and should provide managers with a greater chance of achieving their performance targets, according to Davis.

“The hedge fund sector has tried to aim for 4 per cent to 6 per cent over cash and has not delivered on that objective, but it has its best chance to do it now,” he says.

The industry is also facing up to the problems around transparency, liquidity and redemptions that occurred in the wake of the GFC. This has been a particular problem in certain types of hedge funds, Gosselin notes.

“Fund of funds have had a tougher time and generally those are the managers that have suffered from liquidity issues, as they have generally invested in overseas managers,” he explains.

AFM’s research shows most of the single hedge fund managers in Australia did not have liquidity problems during the GFC. “It is the fund of funds that have had liquidity issues and redemption gates,” Gosselin says.

“Local managers have not had liquidity issues, even those with high redemption rates, as these managers were not investing in overseas markets but in very liquid — even if falling — local markets.”

Despite this, problems remain for hedge fund investors. “There are still a lot of gated funds in the market and this has not been helped by the Lehman collapse, which is delaying the process,” Hopkins explains.

“All of these are being worked out and some funds are doing very well despite the gates.”

However, investor concern over redemption and liquidity problems is forcing the industry to address the issue.

“There is an increasing focus on liquidity as a reaction to the GFC problems,” Davis explains.

“Product developers adapting to this trend are more strongly focused on liquidity than in the past.”

Hopkins agrees: “Investors are increasingly aware that liquidity needs to be more appropriate and assets need to be matched to the [investment] terms.”

The desire for liquidity may also explain the popularity of certain hedge fund strategies since the GFC. “Although they have underperformed recently, CTA has resonated with the retail sector as it is very liquid,” Davis says.

He believes this may affect the types of hedge fund strategies advisers are willing to consider for clients in the future.

“Advisers have long memories when it comes to funds that their clients can’t get out of and advisers are very wary of illiquidity in hedge funds,” Davis says.

Putting it all together

Despite the difficulties some funds have faced in recent years, Gosselin expects hedge funds to play an increasing role within many investors’ portfolios — particularly among more sophisticated clients.

“They will have an increasing role, but it will be dependent on the type of client and the adviser’s knowledge,” he says.

“The sort of investor likely to invest in hedge funds is at the higher end of the high new worth scale — a self-directed investor.”

Gosselin believes hedge funds can make a valuable contribution to a portfolio both in terms of generating alpha and managing risk.

Coop agrees with this opinion, noting that hedge funds remain a core part of Ibbotson’s alternative investment portfolio. He says they remain a “valid diversifier for portfolios dominated by shares” and offer better liquidity than unlisted assets for an alternative investments allocation.

Hedge funds remain an important component of a well constructed investment portfolio for Davis. “We tend to allocate 5 per cent to 8 per cent to alternatives in most client portfolios.

In this bucket we tend to use diversifying hedge fund strategies such as CTAs, global macro, hedge fund of funds and multi-strategy hedge funds to provide a lowly correlated return stream to broader markets, but also to assist in providing alpha in a range of market conditions,” he explains.

Zenith also uses hedge funds as “performance kickers” for traditional asset classes.

“We use market directional hedge funds with the traditional assets classes of Australian and global shares (ie, long-short funds like Platinum International Fund and 130/30 funds like the CFS Acadian Long-Short Fund).

"These funds are used as satellite exposures to generate additional alpha by having more flexible mandates to exploit their skill,” Davis says.

This satellite strategy has added real value and significantly helped performance. However, taking this approach also makes manager selection “pivotal” due to the broader investment mandates used by these funds, he notes.

Gosselin agrees using hedge funds within an investment portfolio needs detailed research and careful manager selection.

“The difficulty is in selecting the good ones. The large managers are the ones that tend to get all the research and ratings,” he says.

“We think investing in a single hedge fund manager is about as sensible as investing in a single share on the ASX.”